The Fed's great rate debate

By Chris Isidore, senior writerFebruary 19, 2010: 4:06 PM ET

NEW YORK (CNNMoney.com) -- The Federal Reserve made it clear Thursday that the hike in its emergency lending rate won't mean a thing for the interest rates paid by consumers and businesses any time soon.

There are plenty of experts who argue that the Fed should move sooner rather than later to raise the federal funds rate, its key lending rate that is used as a benchmark for the interest paid on credit cards, home equity loans and many business loans.

Keeping that rate, also known as the fed funds rate, low is one of the tools used by the central bank to try to spur economic activity. This rate has been near 0% since December 2008.

In its most recent statements, Fed policymakers said they expect the rate will stay "exceptionally low" for an "extended period." It repeated that assurance Thursday.

Still, the Fed surprised markets by raising its discount rate, which is what banks pay to borrow directly from the Fed, to 0.75% Thursday. The move is largely symbolic since that rate affects virtually no borrowing at present.

But Kansas City Fed President Thomas Hoenig argued at the Fed's most recent meeting last month that the promise of low rates risks creating new bubbles in financial markets and lays the groundwork for unacceptably high inflation. He suggested that raising the federal funds rate "modestly higher" soon would lessen those risks.

Many doubt benefits of low rates. Many other experts argued that keeping the fed funds rate this low does not really help the economy. They said it only subsidizes bank profits by keeping their cost of funds exceptionally low.

These critics of Fed policy contend that many consumers and investors have been hurt by the low rates and that they are a reason banks have not been lending.

"One of the reasons lending is having such a hard time getting off the ground is that interest rates are so low," said Brian Wesbury, chief economist at First Trust Portfolios. "Why would someone lend to a risky small business at 3.5%, especially if you expect rates to go up?"

Others argue it's not the level of interest rates that is determining the amount of lending taking place, but banks' concerns about losses on previous loans coupled with borrowers' worries about their ability to repay loans. In other words, a rate hike might not hurt loan demand as long as the economy is improving.

"The Fed economists assume that the cost of money is all that matters. But when you have losses as high as today, that's all the bankers have time to think about," said Christopher Whelan, managing director of Institutional Risk Analytics.

Few businesses or consumers who are looking to borrow to today's rates would be priced out of the market if rates rose one or even two percentage points, according to Richard Bove, a bank analyst at Rochdale Research.

"If I'm a business and I believe the economy is growing, the fact that the fed funds rate is 0% or 1% won't impact my decision to hire people or restock inventory," Bove said.

But few expect the Fed will boost the fed funds rate any time soon. Fed fund futures on the Chicago Board of Trade were little changed Friday even after the rise in the discount rate. The futures forecast only about a 50% chance of an increase to 0.5% by September of this year.

St. Louis Fed President James Bullard said at a speech Thursday night that the rise in the discount rate should not be considered "a warning shot" of higher rates to come, and that the fed funds rate is likely to stay unchanged for the rest of this year.

Low rates have their advocates. There are still plenty of Fed policymakers and other economists who say it's important to keep this rate as low as possible as long as possible, given continued weakness in the U.S. economy.

Fed Chairman Ben Bernanke, who is an expert in the history of the Great Depression, has warned several times that a much stronger recovery early in the course of that downturn was choked off by the Fed tightening too soon. Other central bank policymakers say they want to avoid making that mistake again.

"This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile," said Fed Governor Elizabeth Duke in a speech Thursday night.

Those who believe the low rates are justified say with unemployment still near 10% and consumer prices basically in check, there is no need for the Fed to raise rates.

"I think a rate hike in the near-term would be very disruptive," said Mark Zandi, chief economist with Moody's Economy.com. "Businesses are still very shell-shocked and nervous."

Zandi said even modestly higher rates could lift mortgage rates, which could quickly choke off a recovery in home prices and send mortgage foreclosures higher still.

Kevin Giddis, managing director of fixed income at Morgan Keegan, added that rate hikes are only justified when the Fed needs to slow economic growth in order to battle inflation.

"You see pockets of improvement, but I would stop short of saying we're in recovery," Giddis said. "We're playing with psychology here too. The feeling is we need to see some sustainable improvement in housing and employment before we can take even a small increase in rates."

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